SVP and portfolio manager outlines possible sources of volatility in fixed income, while noting that despite scary headlines, data remains stable
One of the tasks of any advisor in a world of whipsaw markets, social media politics, and hyperbolic rhetoric is to reconcile their clients’ feelings of fear with the stability of hard data. That’s been a perennial challenge in equities, where news about particular companies or earnings reports might set off emotional reactions, but advisors are now having to face some element of fear about the fixed income side of the portfolio, too. Political risks to central bank independence, populist fiscal policies, and unsustainable debt levels in the developed world have some investors fearing that bond volatility may become a meaningful risk to their portfolios.
Darcy Briggs notes that despite a wide range of risks and sources of fear, since the end of the central bank hiking cycle in the developed world bond markets have largely traded within a well defined range. Briggs, SVP & portfolio manager for Franklin Templeton Fixed Income, notes that the MOVE index, as a measure of volatility in bonds, is at its lowest point since the leadup to Russia’s 2022 invasion of Ukraine. Nevertheless, he highlighted emerging areas of potential bond volatility and explained why volatility in fixed income can be so dangerous when it occurs.
“If you have an extremely volatile bond market, every other market is based upon an interest rate. For example, valuations of equities, are based on discounted cash flow and you discount that with the interest rate,” Briggs says. “So if interest rates start becoming unhinged, every other asset valuation will become under pressure as well. A very stable bond market is the basis of a strong financial market.”
Briggs explained that among the possible sources of bond volatility, fiscal policy has now become a major factor. Since the great financial crisis, unsustainable debt levels that had previously been held by households or businesses have been shifted onto government balance sheets. As demographic changes in the developed world place greater strains on social welfare infrastructure, Briggs notes that government fiscal policy has become a potential area of risk for fixed income markets.
Misalignment between monetary policy, fiscal policy, and economic data can also result in volatility onset. Briggs notes the example of the Fed’s ‘jumbo’ 0.5 per cent rate cut in 2024, which actually prompted yields to move higher. Bond investors, he says, saw a situation where data didn’t support policy and reacted accordingly.
On the fiscal side, arguably the best-known recent example was the bond market reaction to British Prime Minister Liz Truss’ mini budget in 2022, which proposed such a dramatic set of tax cuts as to prompt a bond market revolt that nearly destroyed several pension funds in the UK. Briggs notes that there is a degree of risk now associated with higher debt to GDP ratios in the developed world, which might be worsened by political parties promising to cut taxes and increase spending as part of a populist platform. Now France’s frequent political crises are prompting a rise in yields, and Briggs notes that many of the debt trajectories that developed countries are on is “unsustainable.”
“The problem is too much debt. You don't see it so much in the front end of the curve but you see it in long bonds that's where you see volatility,” Briggs says. “Especially when it comes to the sustainability of public finances because up until now there was a free lunch but now the free there's no free lunch.”
Briggs believes that advisors need to be watching the data in this environment. He stresses the importance of selecting a duration that suits a client’s time horizon and while politics and fiscal risks are areas to remain aware of, when they begin to make an impact on data is when advisors and investors can react.
Bond volatility, like all volatility, is a product of ‘unknown unknowns,’ Briggs explains. At the same time, clients and advisors may feel as though things are more volatile than they truly are. In those moments, its on advisors to parse between narrative and data for their clients.
“There’s a difference between the narrative and the data,” Briggs says. “There are a lot of headlines, but that’s the media’s job, to get eyeballs. But there seems to be a disconnect between the narrative and the markets, you see that in fixed income markets and in equity markets. But the markets are a discounting machine and when the narrative seems focused on issues like politicizing the Fed, they’re also noting the possibility of lower rates. You can find any narrative to support what you believe, but tracking the data will give you that extra direction.”
